Just when you thought it was safe to go back into the water… Last week’s surprise interest rate cut by the European Central Bank (ECB) may have been taken as good news by the markets, but it was largely a response to the looming danger of deflation in the eurozone. And that is not good news at all.

It is a severe problem of economic forecasting that if you manage to identify a major force that is going to have significant effects, you are rarely able to see quite when these will occur. You can give up, retire or die before the forecast events finally come to pass.

The long-running crisis of the euro is a case in point. Like Mark Twain’s death, forecasts of the euro’s demise have proved premature. Yet at the heart of the simmering crisis lie two debilitating problems with the potential for a devastating interaction. The first is a loss of competitiveness by the peripheral countries, that has left them with depressed levels of GDP and high rates of unemployment. The second is appallingly high government debt.

The response of the eurozone to the debt problem has been to enforce austerity in the form of cuts in government spending and increases in taxes. That has been successful in reducing the size of the deficits in the peripheral countries. The policy for regaining competitiveness has focused on so-called internal devaluation, whereby the peripheral countries force their inflation rates to low levels. Deflation – that is to say, falling prices – if it occurs, would simply be a continuation of this policy. The faster prices fall, the sooner the affected countries will return to full competitiveness.

At first sight, it seems as though these two policies are consistent with each other. After all, the austerity drive helps price and wage increases to moderate because it depresses aggregate demand and releases resources, including labour.

But when you look at the feedback loop from prices to the debt problem, things look much worse. For if prices fall then, even if real GDP is static, its money value would fall.

Meanwhile, the money value of government debt would remain constant. This means that the ratio of government debt to GDP would rise.

As it happens, the ratio of debt to GDP has recently been on a rising trend even without deflation because, although government deficits have fallen in the peripheral countries, any deficit at all means that the stock of debt is rising. Meanwhile, until recently anyway, the GDP of the peripheral countries has been falling.

So what are the chances of deflation happening in the eurozone? Very high. The latest inflation figure showed a drop from 1.1pc to 0.7pc. Nor was this simply the result of a statistical quirk. The core rate of inflation also dropped to only 0.8pc. And in Greece, prices are already falling. The latest inflation figure was minus 1.9pc. Meanwhile, the price index is roughly flat in Ireland, Spain and Portugal. Inflation is stronger in the core countries, but it is still very low – about 1pc in France and 1.3pc in Germany.

What’s more, in September producer price inflation for the eurozone was minus 0.9pc. And wage inflation is very low, too. In the second quarter of this year, hourly wage costs rose by only 0.9pc year on year. In Greece, pay has fallen by about 10pc over the year.

Wage growth may well get weaker across the eurozone as a whole. Unemployment has started to rise again. In September, it stood at 12.2pc, a record high. In Spain and Greece, the rate is more than 25pc.

If external price pressures turn negative because commodity – and especially energy – prices fall, then a drop into deflation would come sooner. This is where the exchange rate of the euro is critical. It has been extraordinarily strong. When it was launched in 1999, the euro traded

at an exchange rate of $1.17. Subsequently, it fell to below parity against the dollar. Yet it has recently been trading at well over 1.30 against the dollar. The strong euro is directly reducing the cost of imports into the eurozone and it is making it more difficult for the zone to export.

The ECB has indicated that it has more ammunition to deploy if things worsen. It may start to impose negative interest rates on banks for making deposits at the ECB. This, plus the threat of quantitative easing or QE, which the Bank has so far shunned, at least in the pure form, may serve to bring down the exchange rate and thus avert the deflation danger.

But I would not bank on it. Divisions in the ECB council will continue to make ECB action hesitant. Germany is not keen on more stimulative measures and it would surely oppose outright QE.

And as we know from the Japanese experience, a hesitant central bank has great difficulty in effecting the all-important psychological changes necessary to stop prices from falling. For deflation is just like inflation. It is at its most dangerous and is most difficult to dislodge when it gets into the mind. Deflation has been lodged in the mind of the average Japanese person for the best part of 20 years.

Germany holds the key to this problem. What is needed for the eurozone is a combination of a weaker euro and stronger growth of German domestic demand, perhaps facilitated by looser fiscal policy. This would mean Germany putting up with a somewhat higher rate of inflation.

Yet there seems no sign of Germany embracing either a weak currency or a boost to demand.

The result is that the eurozone faces many years of grinding austerity, continuing catastrophe in the labour market and a period of very low inflation, or even deflation. As debt ratios continue to rise in the peripheral countries, at some stage the financial markets may come to worry again about their ability to stay in the euro. At that point bond yields will rise, thereby making the fiscal position worse.

The crisis of the euro is a slow-burning affair. Just like Japan. Of course, the eurozone problems are different from Japan’s but they are just as deep-seated. As I argued a few weeks ago, Japan may seek escape from its debt problem though higher inflation. The troubled peripheral countries of the eurozone cannot do that on their own.

They could only do it if the ECB – and Germany – agree. And that looks unlikely. The risk of some countries defaulting, and/or leaving the euro, is still very much with us.

Roger Bootle is managing director of Capital Economics. Email him on roger.bootle@capitaleconomics.com